Saturday, April 3, 2010

Greenspan and Bernanke (part 2): The Era of Sovereign Default

In a previous post we have seen how the Fed Chairmen Greenspan and Bernanke levered up the US economy to a near Ponzi finance level and subsequently tried to steer the discussion in the direction of housing and away from the overall leverage of the economy (of which housing was only a subset). This excess (some level of leverage is obviously good) leverage for the most part did not leave the system yet. Whether for better or worse the deleveraging has been prevented by the actions of the Fed. It undoubtedly saved the economy from some major short-term pain. How serious the long run consequences will be is debatable, but that they will be serious is clear enough. Under conditions of global trade and more importantly of global mobility of capital a credit bubble in a major economy like the US affects the whole globe. As we have argued before, so-called 'decoupling' is an impossibility under existing circumstances. If the deleveraging is inevitable and only a partial deleveraging took place (and even that was mostly rescinded with the help of zero interest rate), how will the world economy deleverage? Deleveraging is essentially a process of debt reduction which can come about by the sale of assets to pay off debts and is usually accompanied by the cascading seloffs and resulting insolvency of all of the weakest and even some of the sound players (one of our next posts will deal explicitly with this process from the perspective of Hyman Minsky's Financial Instability Hypothesis). All this is simple enough, but what if the deleveraging is prevented by the money creation, as it is now? The only possible answer is that deleveraging will take a different form. This is precisely why we are entering an Era of Sovereign Default. When the government essentially socializes leverage, it has to bear all of the consequences up to and including the default risk. To be sure, we are not here arguing that government should not have rescued the financial institutions. Once they were allowed to become as big as they did and do the things that they did, a government bailout was quite necessary in order to avoid a complete meltdown of asset values and the depression (how this situation could have been prevented is a separate topic). So, if the governments took on leverage, how will they carry that burden? They can't, of course. As an example, US economy would have to grow at a double digit pace for a long long time in order to pay off the debts now accumulated in the financial system (this includes both government and private sector debt) and the same is the case with many other economies. So, there is essentially one option: inflation. Inflation is a default without the short-term pain and shame and is available to those governments who can pay off debt with their own 'printing presses'. It is interesting that inevitability of the inflation is agreed to by both the most severe critics of the Fed like Peter Schiff and Marc Faber, as well as by those who very much support the current administration like George Soros (see "Crisis of 2008 and what it means" by him). Our concern is the implications of the current situation for the risk management going forward.

Mechanics of Zero Interest Rates
To look at this same issue from a slighly different angle, let us again consider the arguments of Greenspan and Bernanke which we dealt with in a previous post.
There is a reason beyond self-exoneration for why both Chairman Bernanke and Chairman Greenspan argue that low Fed funds rate did not fuel the housing bubble and why they used the housing bubble to downplay the unprecedented gearing up of the whole US economy in the 2000's. They are, of course, shifting the blame away form themselves, but there is a bigger picture. They are, indirectly (especially Bernanke, since it is his burden now) making arguments for keeping the low Fed Funds rate (even if it is raised to 1 or 2 %, that is still extremely low) indefinitely. Very low interest rates are here to stay for a long time and that has tremendous implications for the extreme event risk.

Whether it is good or bad zero interest rates effectively prevented the deleveraging of the world economy after 2008. Much of the financial leverage had been transferred onto the shoulders of US currency. Interest rate hikes of the sort that Paul Volcker used to stop inflation are now not possible in any foreseeable future when both the US government and the US consumer are highly indebted. To compound this problem much of the US government debt is short term, robbing it of any real flexibility of action. The housing market is being propped up by the low interest rates and may collapse if the rates are raised. Despite all our criticism of Chairman Bernanke's statements, it is clear that he has very few real alternatives. The one that produces the least short term pain and is thus politically acceptable is to slowly inflate the money supply to reduce the debt burden on the economy and the government, all the while making noises about "exit strategy". Neither raising interest rates anywhere close to historic averages nor sales of the toxic assets accumulated by the Fed are even remotely feasible. Thus, inflating the money supply, while trying to keep the consumer inflation in check is the real game of the Fed. Here, they depend on the low cost producers like China continuing to play the game of exporting consumer good deflation to the US in exchange for the ability to ramp up its own productive capacity and push US further into debt. Based on the above fact some observers concluded that US may soon experience hyperinflation and China will become the main player in the world economy. All this may be possible, nay even probable, but we still have ways to go that point.

All these arguments are also strongly supported by the history of the financial markets. After the incredible leveraging up of the world economy that we witnessed under Alan Greenspan, some sort of banking crisis was quite inevitable. Our position here is that it will lead to a sovereign default that can take the form of the orderly inflation or of a rapid currency devaluation (i.e. a currency crisis) for many countries around in the world, including most importantly the United States. The empirical relationship between a banking crisis and a currency crisis is very strong. As Kaminsky and Reinhart argue in a fascinating 1998 paper called "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems":

"Most often, the beginning of banking sector problems predate
the balance of payment crisis; indeed, knowing that a banking crisis was underway helps predict a future currency crisis. The causal link, nevertheless, is not unidirectional. Our results show that the collapse of the currency deepens the banking crisis, activating a vicious spiral."

These relationships are further studied and confirmed in an equally superb 2010 book by Carmen Reinhart and Kenneth Rogoff called "This Time is Different: Eight Centuries of Financial Folly", where they rigorously examine hundreds of years of financial history and crises.

The Trends

1. The Fed will do everything in its power to orderly inflate the dollar supply without causing the currency crisis. China has given every indication that it will play along for the foreseeable future. Chinese are not stupid and are probably already resigned to the fact that they will have to take a significant haircut on all of their dollar assets in order to delay or avoid a global crisis and a painful adjustment to a less of an export driven economy. They appear to favor slow realignment, while keeping the duration of their US debt holdings low. If all this holds up and no external shock (a war, a string of sovereign defaults) occurs, the current situation will continue for some time. The volatility in the US dollar will be quite high, but the currency crisis is not imminent. The current low stock volatility (VIX is at 17) has to go up, but as long as Fed has the flexibility to inject massive liquidity any major drop in nominal equity or real estate prices will not persist.
2. The turning point will come when the US is forced to monetize debt on a large scale (so far, the Chinese are still buying). This can happen as a consequence of a change in China's policy, but that is unlikely in the short term (unless Geitner and Congress succeed in their suicidal push for the Chinese to revalue their currency upward quickly). It will definitely happen if the course that we are on continues to the point when servicing liabilities becomes a significant part of the Federal budget. We are still not there.
3. Though the situation of the US government is dire, it has a major asset in the US dollar, which still remains the world's reserve currency. Other countries do not have such a golden goose. Therefore, as the current slump continues we are likely to see other sovereign debt crises a la Greece (this part of the article was written before the Portugal downgrade) in the shorter term. These sovereign crises will produce a temporary strength in the dollar. This will likely happen before we get to the point of high interest rates in the US and a partial default by inflation. In the era of sovereign default, countries in the Eurozone are the only ones (among the countries whos debt is denominated in their own currency) likely to experience anything remotely resembling a real default (as opposed to default by inflation, which we believe will be endemic). This is because countries within the Euro zone do not really control their own monetary policies. In the long run, this is a strong pro for Euro, but as Lord Keynes aptly and grimly observed once: "In the long run, we are all dead".

Since this post turned out to be much longer that we originally planned, we are breaking it up. Thus, the Part 3 of the Greenspan and Bernanke series, which will contain specific suggestions on the modifications in the structure of the risk management process in light of the developments analyzed in parts 1 & 2 will come out in a few days under the title:
Greenspan and Bernanke (part 3): Implications for a Risk Management Process

The following posts will be as announced earlier:
"Behavioral Finance and Extreme Event Risk: Information Cascades"
"Behavioral Finance and Extreme Event Risk: Disaster and Interrelatedness Myopia"